Abstract

ABSTRACTThe real options approach often assumes that investment projects last indefinitely, which is an unrealistic assumption. When projects live finitely, valuation techniques from American option pricing are required. This article presents a method for pricing American options based on the first-passage approach to the problem. The key is to correct the error associated with the price obtained from a rough first approximation. The procedure leads to a significant reduction in error corresponding to the initial approximation. As a particular case of the method proposed, we derive a closed-form approximation of the option price. The existence of a closed-form approximating formula (that does not involve iterative methods) keeps the computational cost low. In terms of accuracy, the method can be compared to much more sophisticated methods. A tight lower bound (given in closed form) is also provided. The method is fast, accurate, flexible, and easy to implement. A spreadsheet suffices for practical implementation.

Talk to us

Join us for a 30 min session where you can share your feedback and ask us any queries you have

Schedule a call

Disclaimer: All third-party content on this website/platform is and will remain the property of their respective owners and is provided on "as is" basis without any warranties, express or implied. Use of third-party content does not indicate any affiliation, sponsorship with or endorsement by them. Any references to third-party content is to identify the corresponding services and shall be considered fair use under The CopyrightLaw.